We examine the relationship between directors' and officers' liability insurance (D&O insurance) and the sensitivity of directors' compensation to firm performance.

We find that instead of providing positive incentive to boards of directors, D&O insurance may actually worsen the agency problem.

Using 5619 firm-year observations of 1236 listed firms in Taiwan during the period from 2008 to 2012, we show that D&O insurance reduces the sensitivity of directors' compensation to firm performance by approximately 42 percent for the insured firms.

As a result, instead of alleviating agency problem, D&O insurance actually increases firms' agency costs.